Introduction
Background to proposed change
Reasons for change
Exclusion of debt-to-equity conversions
Anti-avoidance: five-year degrouping rule
Clawback of interest previously incurred and deducted
The Income Tax Act (58/1962) contains rules regarding the manner in which a taxpayer must account for the benefit derived from the waiver, cancellation, reduction or discharge of a debt that it owes. The tax implications arising in respect of a debt reduction depend mainly on whether the loan funding was used to fund tax-deductible expenditure, such as operating expenses, or capital or allowance assets. The debt reduction rules apply only to the extent to which the waiver, cancellation, reduction or discharge gives rise to a 'reduction amount' – in other words, the amount by which the decrease in debt exceeds the consideration received by the creditor in return.
In the existing economic climate, various mechanisms exist by which a debtor may settle a debt with a creditor or a creditor may relinquish a claim to have the debt repaid. One such mechanism is the conversion of debt owed by a company into equity in that company. For example, a company may reduce its debt by:
- issuing shares directly to a creditor in full and final settlement of the debt;
- issuing shares for an amount payable in cash and offsetting the subscription price owed by the subscriber against an amount owed by the company;
- converting debt to shares in fulfilment of the conversion rights attaching to the debt (eg, convertible debentures); or
- issuing shares to the creditor in exchange for cash and then applying the cash against the debt owed by the company.
These types of debt conversion scheme are usually entered into in respect of loans advanced to a company by the controlling shareholder of that company. The shareholder in effect converts a debt claim against the company to equity financing. This arrangement is aimed at improving the company's balance sheet and retaining its financial sustainability. The South African Revenue Service (SARS) has issued a number of binding private rulings providing relief in respect of the application of the existing tax rules where a debt owed by a company to its controlling shareholder is reduced or discharged in terms of an arrangement that in effect converts that debt into equity. The most recent rulings include Binding Private Ruling 246 and Binding Private Ruling 255.
The Draft Explanatory Memorandum on the Taxation Laws Amendment Bill 2017 states that the conversion of debt into equity is aimed at restoring or maintaining the solvency of companies in financial distress without triggering the debt reduction rules. It further states that the shareholder or creditor envisages, in effect, the outcome that would have been achieved had that shareholder originally funded the company by means of an equity contribution rather than the debt so converted. As a result thereof, the dispensation governing such arrangements should therefore be aimed at achieving, in broad terms, the outcome that would have been achieved had the creditor funded the company by means of an equity contribution rather than a loan.
Exclusion of debt-to-equity conversions
In order to assist companies in financial distress, it has been proposed that definitive rules dealing with the tax treatment of conversions of debt into equity be introduced. The Draft Taxation Laws Amendment Bill 2017 therefore proposes that the rules dealing with a debt that has been cancelled, waived or discharged should not apply to a debt that is owed by a debtor to a creditor that forms part of the same 'group' of companies (as defined in Section 1 of the Income Tax Act in order to include multinational groups of companies). The bill therefore proposes the insertion of a further exclusion from the application of Section 19 of the Income Tax Act where one group company is indebted to another and the debt is reduced or settled, indirectly or directly, by means of shares issued by the debtor group company.
A similar exclusion is proposed in respect of debt utilised to fund capital and allowance assets contemplated in Paragraph 12A, Schedule 8 of the Income Tax Act.
While several SARS rulings imply that parties could capitalise shareholder loans without triggering the debt reduction rules, the insertion of the specific exclusions in Section 19 and Paragraph 12A, Schedule 8 of the Income Tax Act now specifically codifies this exclusion. Notably, the specific exclusion in respect of the issue of shares and the reduction of debt does not extend to a non-group context. This is based on the fact that it has come to the government's attention that creditors and debtors are entering into short-term shareholding structures that seek to circumvent tax implications triggered by the application of these rules. Therefore, to the extent that two non-group companies enter into a similar arrangement, one would still apply the ordinary principles which may result in the trigger of the debt reduction rules depending on the specific factual circumstances.
Anti-avoidance: five-year degrouping rule
Notwithstanding the specific relief proposed within a group context, in order to counter abuse of the abovementioned relief by taxpayers which simply wish to cancel, waive or discharge a debt without any tax consequences and do so with no real interest in the indebted company's financial recovery, it is proposed that the creditor and the debtor be required to continue to form part of that same group of companies for at least five years from the date of the conversion. The extent to which the companies degroup within five years may trigger the ordinary application of the relevant debt reduction rules. This relief will apply in respect of debt governed by both Section 19 and Paragraph 12A, Schedule 8 of the Income Tax Act.
Further proposal: clawback of interest previously incurred and deducted
Where the conversion of debt into equity does not trigger the application of the rules dealing with the tax treatment of debt that is waived, cancelled, reduced or discharged, it is further proposed that the tax consequences be similar to those that would have applied had the creditor or shareholder funded the company by means of an equity contribution rather than a loan (ie, as if the loan had always been an equity investment).
As a result, the following is proposed:
- Any interest that was previously deducted by the borrower in respect of a debt that is subsequently converted into equity should be treated as a recoupment in the hands of the borrower to the extent to which that interest was not subject to normal tax in the hands of the company which received it or to which it accrued.
- The amount that must be recouped must first be used to reduce any assessed loss of that debtor company in the year of assessment that the debt-to-equity conversion takes place.
- One third of any balance exceeding that assessed loss must be treated as a recoupment in each of the three immediately succeeding years of assessment.
Should the debtor and the creditor cease to form part of the same group of companies within the prescribed three-year period, any remaining balance of the interest previously deducted by the debtor must be included in the debtor's taxable income in full in the year of assessment in which they cease to form part of the same group of companies.
The proposed amendments will take effect on January 1 2018.
For further information on this topic please contact Jerome Brink at Cliffe Dekker Hofmeyr by telephone (+27 115 621 000) or email ([email protected]). The Cliffe Dekker Hofmeyr website can be accessed at www.cliffedekkerhofmeyr.com.